Whose money will prevail as reserve currency?

October 20, 2009


-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

If there is one foreign exchange story that will run and run it is the one about the U.S. dollar (USD) and its future as the world’s dominant reserve currency.  The discussions on this topic have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix change.  That said, much uncertainty remains as to what can, if anything, eventually replace the dollar.

The basis for questioning the USD’s position as global reserve currency stems from its declining value and its “poor” fundamentals.  The dollar index is currently trading close to where it was 14 mpnths ago, ahead of the financial crisis.  At that point the USD had been on a downtrend for over two years. The widening in the U.S.’s budget deficit this year has worsened the fundamental backdrop and drawn attention to its “twin deficits”.  This has made creditor nations nervous. 

So, how bad are these fundamentals?

The U.S. current account deficit this year has actually improved.  However, once the U.S. recovery gets underway, many expect to see the current account widen again.  Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance.  This is not always the case.  Australia presently has a current account deficit of around 4.5 percent of GDP and the effective Australian exchange rate has rallied by 27 percent since January 1, 2009. 

Current account imbalances, while always a potential currency negative, only weigh if international savers become less keen to fund it.  Investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence.   A huge USD negative this year has been the widening in the budget deficit to potentially 11 percent of GDP from 4.7 percent in 2008.   This implies huge bond issuance. 

To date, Treasury auctions have been well subscribed.  While supply has not caused the USD any clear problems, budget deficits of this size inevitably imply fiscal spending cuts which could weigh on growth for years.  This suggests limited growth in addition to low short-term interest rates which is a poor currency dynamic.

While a strong budget position is highly desirable for a reserve currency it is not the only factor.  Clearly a reserve currency needs to be fully convertible.  This requirement counts out the Chinese yuan (CNY).  The ability to cope with huge liquidity demands excludes currencies such as the Norwegian krone, Australia dollar and the New Zealand dollar.  The euro (EUR) fails the criteria insofar as there is no single sovereignty.  

Some argue that differing fiscal policies in the Economic and Monetary Union (EMU) have the potential to lead to friction, while others stress the geopolitical line that the absence of a single policy on defence would for some countries mean that the EUR would be an inadequate USD replacement.  This does not mean that the EUR will not take a greater role in the coming years.  There are signs that central banks have slightly increased their holdings of EUR along with the Japanese yen (JPY) this year and this trend may continue.

Looking forward, assuming U.S. fundamentals remain poor it is feasible that talk of a basket of reserve currencies will eventually become more relevant with the EUR and the JPY potentially playing a greater role and even the CNY playing a part in the next decade or so.  However, any adjustment in central bank currency reserves will be slow and is unlikely to lead to any tangible downward pressure on the USD particularly since creditor nations have an interest in protecting the value of their holdings.  As a result, any additional USD declines are likely to remain orderly.



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